How to Avoid the Worst Sector ETFs 4Q16

Answer: ETF providers tend to make lots of money on each ETF so they create more products to sell.

The large number of ETFs has little to do with serving your best interests. Below are three red flags you can use to avoid the worst ETFs:

Inadequate Liquidity

This issue is the easiest to avoid, and our advice is simple. Avoid all ETFs with less than $100 million in assets. Low levels of liquidity can lead to a discrepancy between the price of the ETF and the underlying value of the securities it holds. Plus, low asset levels tend to mean lower volume in the ETF and larger bid-ask spreads.

High Fees

ETFs should be cheap, but not all of them are. The first step here is to know what is cheap and expensive.

To ensure you are paying average or below average fees, invest only in ETFs with total annual costs below 0.49%, which is the average total annual costs of the 189 U.S. equity Sector ETFs we cover. The weighted average is lower at 0.27%, which highlights how investors tend to put their money in ETFs with low fees.

Figure 1 shows PowerShares KBW High Dividend Yield Portfolio (KBWD) is the most expensive sector ETF and Schwab US REIT ETF (SCHH) is the least expensive. No one provider provides more than one of the most expensive ETFs while Fidelity ETFs (FENY, FMAT, FIDU, FDIS) are among the cheapest.

Figure 1: 5 Least and Most Expensive Sector ETFs

Sources: New Constructs, LLC and company filings

Investors need not pay high fees for quality holdings. Fidelity MSCI Financials Index ETF (FNCL) earns our Very Attractive rating and has low total annual costs of only 0.09%.

On the other hand, Fidelity MSCI Telecommunications Services Index (FCOM) holds poor stocks and earns our Dangerous rating, yet has low total annual costs of 0.09%. No matter how cheap an ETF, if it holds bad stocks, its performance will be bad. The quality of an ETFs holdings matters more than its price.

Poor Holdings

Avoiding poor holdings is by far the hardest part of avoiding bad ETFs, but it is also the most important because an ETF’s performance is determined more by its holdings than its costs. Figure 2 shows the ETFs within each sector with the worst holdings or portfolio management ratings.

Figure 2: Sector ETFs with the Worst Holdings

Sources: New Constructs, LLC and company filings

State Street (XBI and XME) and Fidelity (FEBT and FREL) appear more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings.

State Street SPDR S&P Biotech ETF (XBI) is the worst rated ETF in Figure 2. First Trust Utilities AlphaDEX Fund (FXU) and iShares US Telecommunications ETF (IYZ) also earn a Very Dangerous predictive overall rating, which means not only do they hold poor stocks, they charge high total annual costs.

Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. Put another way, research on ETF holdings is necessary due diligence because an ETF’s performance is only as good as its holdings’ performance. Don’t just take our word for it, see what Barron’s says on this matter.

Scottrade clients get a Free Gold Membership ($588/yr value) as well as 50% discounts and up to 20 free trades ($140 value) for signing up to Platinum, Pro or Unlimited memberships. Login or open your Scottrade account & find us under Quotes & Research/Investor Tools.